Agence du revenu du Québec v. Custeau, 2020 QCCA 1496

When a family small business corporation (the “Corporation”) was in financial difficulty, a Quebec regional development fund and affiliated fund (the “Funds”) agreed (with an objective of saving jobs in the region) to inject equity capital in the Corporation on terms largely dictated by them – which entailed the funds investing (in 1997 and 1998) in the common shares of the Corporation (or in shares that were converted into the common shares of the Corporation), so that the paid-up capital of the taxpayers’ shares was boosted from a nominal amount to $1.45 million due to PUC averaging. In 2003 and 2004, the taxpayers (who were two brothers) engaged in capital gains crystallization transactions in which they transferred most of their common shares of the Corporation to personal holding companies, realizing capital gains of $1 million, and took back preferred shares with a correspondingly stepped-up adjusted cost base and also a paid-up capital that reflected the PUC that had in effect been transferred from the shares that the Funds had previously subscribed for. The Funds' common shares of the Corporation were repurchased in 2005, and the taxpayers had their Holdcos distribute most of the PUC of their preferred shares in cash during 2006.

The ARQ considered there to have been abusive surplus-stripping, and applied the Quebec general anti-avoidance rule to treat most of the paid-up capital distributions as taxable dividends. Dortélus JCQ had found that the utilization by the taxpayers of their stepped-up PUC in 2006 was not part of the same series of transactions as the 1998 PUC-averaging transactions. At para. 71 of his judgment, he accepted the taxpayers’ submission that in order to analyze the nexus between the 1998 and 2006 transactions “it is necessary to place oneself in 1998, at the time of the first transaction and not to apply a backwards-looking analysis.” The ARQ submitted that this approach erred by not recognizing that Copthorne had found that the assimilation to a series of transactions of related transactions completed “in contemplation” of the series included backwards-looking contemplation.

In rejecting this submission, Schrager JCA noted that Canada Trustco had indicated that the "in contemplation" phrase "can be applied to events either before or after the basic avoidance transaction" [emphasis added] and then stated (at paras. 45, 49, TaxInterpretations translation):

Rothstein J., speaking [in Copthorne] added that each case must be decided on its own facts. This is exactly what was done by the judge in paragraph 71 of his judgment. I reiterate his factual conclusion that in 1998, no one could have predicted that the Corporation would generate sufficient cash to fund the 2005 and 2006 share repurchases. I read nothing in Copthorne that leads me to conclude that in this case the judge should have analyzed the series of transactions prospectively and retrospectively. The excerpt from Trustco shows that this may be an alternative exercise depending on the circumstances of the case. … Copthorne … approved both approaches because each situation is an individual case. Here, the judge looked forward from 1998 when the transactions giving rise to the tax benefit were carried out. Thus, he did not commit an error of law. Certainly, the passage of time (8 years) and the events that occurred during this period (rendering the Corporation profitable) are relevant elements. The retrospective analysis proposed by the appellant is an effort to recharacterize the 1998 share subscriptions and transfers. In 2006, the respondents clearly took advantage of a situation created in 1998, but the nature of those transactions was commercial and not fiscal. There is certainly not a "close nexus" [quoting from Copthorne at para. 47] between the 2006 and 1998 transactions. ...

It is true that the dilution of capital could have been avoided by the creation of three distinct classes of common shares in this case, as raised at the time by a representative of the Regional Fund (a mention that did not attract the attention of the counsel for the respondents, according to his testimony accepted by the judge). This possibility does not render the judge's factual conclusions erroneous. As he noted, none of the players in 1998 could have foreseen that the business would generate sufficient cash six or eight years later to allow the shares to be redeemed. ... The nature of the transaction was clearly commercial and not fiscal, as the judge correctly decided.

When a family small business corporation (the “Corporation”) was in financial difficulty, two Quebec regional development funds agreed in 1997 and 1998 (with an objective of saving jobs) to inject equity capital in the Corporation on terms largely dictated by them. As a result of paid-up capital averaging that occurred in the 1998 transactions, the PUC of the common shares of the taxpayers (two brothers) was boosted by a significant amount. In 2003 and 2004, they engaged in capital gains crystallization transactions, which resulted in them holding their shares through respective Holdcos whose shares had a stepped-up ACB and a PUC that reflected the PUC that had effectively been transferred to them. The funds’ common shares of the Corporation were repurchased in 2005 (the Corporation had done quite well), and the taxpayers had their Holdcos distribute most of their PUC in cash during 2006.

The ARQ considered this to be abusive surplus-stripping, and applied the Quebec general anti-avoidance rule to treat most of the paid-up capital distributions as taxable dividends. Dortélus JCQ had found that the utilization by the taxpayers of their stepped-up PUC in 2006 was not part of the same series of transactions as the 1998 PUC-averaging transactions, stating that in order to analyze the nexus between the 1998 and 2006 transactions “it is necessary to place oneself in 1998, at the time of the first transaction and not to apply a backwards-looking analysis” (TaxInterpretations translation). The ARQ submitted that this approach had erred by not recognizing that Copthorne had found that the assimilation to a series of transactions, of related transactions completed “in contemplation” of the series, included backwards-looking contemplation (i.e., the 2006 transactions were effected “in contemplation” of the previous PUC step-up in 1998.)

In rejecting this submission, Schrager JCA found that, consistently with Copthorne, the question of whether the “in contemplation of” test as to a series should be applied prospectively or retrospectively, depended “on the circumstances of the case” (para. 45). In the circumstances of this case, including that “none of the players in 1998 could have foreseen that the business would generate sufficient cash six or eight years later to allow the shares to be redeemed” (para. 49), Dortélus JCQ had not erred by applying the “in contemplation of” test looking forward from 1998 rather than backwards from 2006. It followed that the 1998 PUC-averaging transactions and the use of that PUC in 2006 were not avoidance transactions for GAAR purposes.